As we communicated in the past, the equity markets can and will be volatile – both to the upside and downside! This past week was another example. We will summarize the past week and explain why the discussion of stocks has expanded beyond CNBC into virtually all news and media, complete with late-night comedian monologues and Saturday Night Live sketches. We will do this in a Q&A format.
Why is everyone talking about a few stock names like GameStop, AMC Entertainment, Blackberry and Bed, Bath & Beyond? What happened?
At its simplest level, we had market trading events known as “short squeezes”. When an investor believes that a stock is overpriced, one way to express this bet is by shorting the stock. With the proper trading platform, investors can borrow stocks from other investors (at a cost) and sell at the current price, say $100. This is called “shorting” a stock. The investors are hoping the stock price will fall in a relatively short period of time, so they can “cover” their short position (buy shares), eliminate borrowing costs, and realize a profit (if the stock fell to $10, investors would buy back shares and realize $90 gain, less borrowing costs). Investors generally short stocks they believe have poor and/or deteriorating fundamentals such as GameStop, a brick-and-mortar company that is expected to continue losing customers to online shoppers. Many traders/investors have been short this stock (in fact they borrowed more than 100% of the stock). These investors are exposed to a “short squeeze”, which is when the stock price starts moving up either due to better than expected fundamental news or traders/investors aggressively purchasing the stock to bid up the price. When you are in a short position, losses are theoretically unlimited (no upper bound on price, in our example if the stock goes from $100 to $1000 investors may be forced to “cover” their short position and lose $900). If investors are forced to cover their short positions en masse the stock price can rapidly and dramatically move even higher.
This unusual week can best be seen in a share volume chart of GameStop. For the majority of 2020, the average daily share volume was less than five million shares per day. Last week, GameStop had multiple days with over 100 million shares traded, fueled by a frenzy over social media and online trading platforms that have surged in popularity.
This has happened in the past, correct?
Yes, this is a normal market phenomenon, and it highlights the risk of being short a stock. One example that people may remember is from 2008 when Volkswagen became the largest company in the world for a day or two due to a short squeeze.
Why did these stories move beyond the financial press into all news outlets? Why is my mother-in-law asking?
This echoes the current political, economic, and cultural themes of our time, essentially an anti-establishment bias. When COVID-19 arrived in the U.S. and people started working from home, there was an exponential increase in brokerage accounts from your online trading platforms like Robinhood to established brokerages like Schwab and Fidelity. This led the “retail investors” (i.e., individuals) to a harness a larger percentage of market activity and trading. Additionally, online financial message boards grew in popularity and numbers – the most notable is the subreddit called r/wallstreetbets. People have been crowdsourcing trading ideas on these sites. Starting in the latter half of 2020, retail investors started to purchase GameStop – both shares outright and call options (a leveraged way to bet on a stock price to increase). This frenzy gained momentum and reached a tipping point last week. Remember, the retail side of trade is betting GameStop’s price to increase. On the other side, there were some notable and large hedge funds (loosely regulated pools of capital) that were short GameStop, betting on a price decline. They were surprised by the size, speed, and organization of the buying activity going against them. Many hedge funds lost billions of dollars in a matter of days. One of the portrayals in the media is “Average Joes” beating “Wall Street” at its own game. Many outsized voices from Silicon Valley sided with Average Joes, adding fuel to the fire. Additionally, U.S. politicians have weighed in and are demanding hearings. As we enter this week, there are now large players on both sides of this trade. Anecdotally, there was a small plane flying over Miami Beach last week pulling a banner that read, “Buy GameStop”.
Is the volatility in these specific stocks over?
While we do not know for sure, we believe this will continue to play out over the next couple of weeks and months. As we noted above, these events have happened in the markets before. However, at some point, the underlying fundamentals of a company like GameStop will likely not be able to sustain current price. We continue believe in the efficiency of capital markets that will reward companies providing valuable products/services and diminish those failing to perform.
What are the regulators, such as the Securities and Exchange (“SEC”) going to do?
The SEC is currently reviewing the volatility in these names and has vowed to protect the retail investor (there was additional backlash this week as Robinhood and other trading platforms blocked trades of GameStop and other stocks, accelerating sentiments of anti-establishment). There are many facets and, hopefully, the SEC conducts a thorough review of all stakeholders to determine if any malfeasance occurred and uncover areas for improvement going forward.
Is short selling illegal?
No, it is not. It can serve as a valuable tool in free and efficient markets as it not only helps with price discovery but also identifying bad actors. One the most notable U.S. examples is Enron. The short sellers of this stock were the first to notice that the financials were fraudulent. As a more recent example, the German company Wirecardwas “attacked” by short sellers. Before it was proven there was fraud, German regulators actually banned short selling in Wirecard for a period of time, which delayed the ultimate recognition of fraud at the company. Remember the markets work best when it aggregates every investors’ opinion, the opinion of all market participants is shown as the price of each stock.
Since the extreme volatility was in a few, specific stock names, how did the broader equity and bond markets do?
Below, please see a chart that displays the past week’s (1/25 – 1/29) returns for the S&P 500 Index, Russell 2000, MSCI EAFE International equity indices. We are utilizing ETF proxies for the respective index returns. We are also showing a chart for the Bloomberg Barclays US Aggregate Bond and Bloomberg Barclays Municipal Bond.
The broader equity markets experienced a down week (after huge gains over the last few months), but we do not believe the GameStop news story was a dominant factor. Markets are grappling with evolving news around stimulus, employment numbers, Fed decisions, vaccination rollouts, etc. Additionally, municipal bonds were positive on the week and taxable bonds were slightly negative. Interestingly, you can see January 27th where the Russell 2000 started lower and finished up for the day, while the S&P was down. Many of the stocks like GameStop are small cap stocks which is part of the Russell 2000.
Thoughts going forward?
We believe stories like GameStop will stay in the headlines. If for nothing else, they make for entertaining news. Next week, month, year there could be heretofore unknown stocks that spike interest and splash across the front pages. Maybe this is naïve optimism, but we are hopeful that the regulatory agencies, politicians, and Wall Street can work together in continuing transparency and democratization of our capital markets. We were reminded again the importance of sticking to a well thought out, disciplined investment plan, and the benefits of diversification. This week highlights the idiosyncratic risk of single stock positions and how globally diversified allocations can not only produce long-term returns but also dampen volatility.
If you have questions, please don’t hesitate to contact us today.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.